A Question of Power

Recently, there has been growing recognition of the enormous increase in U.S. income inequality that has occurred over the last twenty-five years, bringing back inequality levels not seen since 1929. Paul Krugman has written of the danger of a new oligarchy, whose wealth is such that it may be able to control an economy and society even as large as the United States.

So real is growing inequality that even libertarian-minded Alan Greenspan has mused on its dangers to â€œdemocratic societyâ€ â€“ though his fear is not the undemocratic character of oligarchy, but rather that too much inequality may promote economically disruptive political rebellion from below.

This expanding recognition of the income distribution problem by the prominent and powerful is extremely welcome. However, it raises the question â€œwhat is the cause?â€ One short answer is changed economic power between workers and corporations. This change has affected wage bargaining and whose interests get taken into account in business and economic policy decision-making. The power explanation stands in sharp contrast to economistsâ€™ stories about increased income inequality being due to rising returns to skill and education. What is so important about the power story is that it torpedoes the standard explanation of income distribution. And with it sinks much other economics about the adverse effects of trade unions, the idea of a natural rate of unemployment, and many claims about the benefits of globalization.

The power story has been around for a long time, but now the economic data have become so clear that it is forcing itself upon the business friendly economics profession. A recent research paper by Becker and Gordon of Northwestern University, â€œWhere Did the Productivity Growth go?â€ reports that productivity growth has been largely captured by those in the top one percent of the income distribution, especially those in the top one-tenth of one percent. This challenges full on the conventional wisdom that rising income inequality is due to increased economic premiums to skill and education. Wage and salary income of individuals at the 90th percentile grew just 34 percent between 1972 and 2001. Thatâ€™s about the rate of productivity growth, so being a college graduate earned normal returns and was not a ticket to the income stratosphere.

This finding should come as no surprise. For the past two decades the Economic Policy Institute has documented rising income inequality in its bi-annual publication, The State of Working America. The 2004 edition reported that hourly wages of those with less than a college degree fell between 1979 and 2003; wages of college degree holders rose by less than one percent a year over that period; and those of advanced degree holders grew by less than 1.1 percent per year. Consequently, the notion of enormous returns to education is a myth.

Despite these facts, the economics profession has continued touting its education story, which confuses correlation and causation. Wages of college-educated persons grew fairly normally over the last thirty years, but wages of those with less than a college degree fell. Ergo, the increase in income inequality was positively correlated with educational attainment, but returns to education were normal and not the cause of increased inequality.

The education story has been popular because it serves the social and political purposes of the powerful and favored. First, it implicitly blames the victims for their plight. Workers are responsible for their condition, having been too stupid or lazy to finish high school and go to college. With glib ease, Washington â€œsuitsâ€ can then dismiss amazingly skilled welders, mechanics, and blast furnace operators as unskilled. Second, the education story allays fears about globalization and rising corporate power because these supposedly have little to do with rising inequality, which is instead attributed to skill-rewarding technological change. Third, investing in education provides a convenient solution for elite policymakers. Fourth, the education story is consistent with the dominant economic theory of income distribution, and therefore saves that theory.

That dominant theory (known as marginal productivity theory) claims that free markets ensure that workers are not exploited and are paid their contribution to production. The logic is that markets prevent exploitation since a firm that wonâ€™t pay a worker her contribution will find that worker poached away by another firm that is willing pay slightly more.

The education hypothesis fits neatly with this theory. The claim is that technology has increased the productivity of more educated workers, and firms operating in competitive markets have therefore increased wages of these workers. The only problem is the facts donâ€™t fit the theory. Returns to education have not been stellar and cannot explain the pattern of wage and income change that has occurred.

The marginal product theory of economists has always appealed to the elite, being a combination of explanation and justification of income distribution. Free markets pay workers what they are worth, justifying wages and explaining them. Furthermore, free markets prevent exploitation, making unions and minimum wages unnecessary. Indeed, the theory allows the rich and powerful to claim that these essential worker protections are bad and increase unemployment by pricing workers out of jobs.

The conventional economic theory of income distribution has always been a stretch. Like beauty, a workerâ€™s contribution is in the eye of the beholder, which raises the question of whose eye. It has now become clear that the theory does not explain the worsening of income distribution. That means another theory is needed â€“ one that admits the role of power, institutions, and socially created perceptions of who adds value. Rather than skilled welders and machinists needing retraining, it is economists that need re-training and re-education.

Copyright Thomas I. Palley

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4 Responses to “A Question of Power”

My impression of the marginal productivity theory is that it assumes the labor supply is competitive (demand exceeds supply) which is rarely true, especially as labor markets become global. As a market becomes more competitive, the price that a firm sets for a good or service tends to an equilibrium of zero profit. The zero profit condition for labor translates into poverty wages - just enough to survive and produce offspring. This is true regardless of labor productivity. Education can benefit the individual by making him more competitive in the labor market, but at the expense of his peers who become less competitive in relative terms. The economy as a whole benefits from education by increased productivity, but wages overall stagnate or decrease since the bargaining power of labor actually decreases as the supply of skilled labor increases. Therefore, the productivity increases realized by a more educated worksforce are generally accrued as increasingly higher profits and executive compensation.

thanks for your posting about wages and power,
I’m interested in a similar phenomenon in the international context - the returns to multinationals who earn ‘rents’ from technologies and brands, while their workers, who appear extremely productive, get very little - are you aware of any efforts to model the impact of power on wages/profits to various groups in a supply chain? I’m interested in dynamic systems models or agent based models, as I doubt standard equilibrium models can do much.
I’m not an economist by training, but a professor of management.

This is a very interesting topic. The unfortunate part about it are the differences of opinion I read/hear on the matter. For example, nightly economic shows such as Cudlow and Company deride the idea of a growing inequality among Americans–According to him and his ilk, everyone is doing great–just like the economy. For every claim for growing inequality, these magicians on his show use their hocus pocus stats to refute any negative claim. If you listen to shows like this enough, you begin to think everything is positive for the economy…Interest rates, home prices, the trade defict, or the value of the dollar….Up or down, high or low, it’s always good according to these people.